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REGULATORY IMPACT ANALYSIS

For

Risk-Based Capital Guidelines; Capital Adequacy Guidelines;

Capital Maintenance: Standardized Risk-Based Capital Rules

(Basel II: Standardized Option)

2008

Office of the Comptroller of the Currency

International and Economic Affairs

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REGULATORY IMPACT ANALYSIS Executive Order 12866 requires federal agencies to prepare a regulatory impact analysis

for agency actions that are found to be “significant regulatory actions”. Significant regulatory actions include, among other things, rulemakings that “have an annual effect on the economy of $100 million or more or adversely affect in a material way the economy, a sector of the economy, productivity, competition, jobs, the environment, public health or safety, or State, local, or tribal governments or communities.”1 Regulatory actions that satisfy one or more of these criteria are referred to as “economically significant regulatory actions.”

Based on the OCC’s estimate of the number of national banks likely to adopt this proposal and the proposal’s total cost of approximately $74 million, the proposed rule would not have an annual effect on the economy of $100 million or more. In light of certain unique features of the proposal, the OCC has nevertheless prepared this regulatory impact analysis. Specifically, this proposal affords most national banks the option to apply this approach, which results in additional uncertainty in estimating the total costs.

In conducting the regulatory analysis for an economically significant regulatory action, Executive Order 12866 requires each federal agency to provide to the Administrator of the Office of Management and Budget’s Office of Information and Regulatory Affairs (OIRA):

• The text of the draft regulatory action, together with a reasonably detailed description of the need for the regulatory action and an explanation of how the regulatory action will meet that need;

• An assessment of the potential costs and benefits of the regulatory action, including an explanation of the manner in which the regulatory action is consistent with a statutory mandate and, to the extent permitted by law, promotes the President's priorities and avoids undue interference with State, local, and tribal governments in the exercise of their governmental functions;

• An assessment, including the underlying analysis, of benefits anticipated from the regulatory action (such as, but not limited to, the promotion of the efficient functioning of the economy and private markets, the enhancement of health and safety, the protection of the natural environment, and the elimination or reduction of discrimination or bias) together with, to the extent feasible, a quantification of those benefits;

• An assessment, including the underlying analysis, of costs anticipated from the regulatory action (such as, but not limited to, the direct cost both to the government in administering the regulation and to businesses and others in complying with the regulation, and any adverse effects on the efficient functioning of the economy, private markets (including productivity, employment, and competitiveness), health, safety, and the natural environment), together with, to the extent feasible, a quantification of those costs; and

1 Executive Order 12866 (September 30, 1993), 58 FR 51735 (October 4, 1993), as amended by Executive Order 13258, 67 FR 9385 (February 28, 2002) and by Executive Order 13422, 72 FR 2763 (January 23, 2007). For the complete text of the definition of "significant regulatory action," see E.O. 12866 at § 3(f). A "regulatory action" is "any substantive action by an agency (normally published in the Federal Register) that promulgates or is expected to lead to the promulgation of a final rule or regulation, including notices of inquiry, advance notices of proposed rulemaking, and notices of proposed rulemaking." E.O. 12866 at § 3(e).

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• An assessment, including the underlying analysis, of costs and benefits of potentially effective and reasonably feasible alternatives to the planned regulation, identified by the agencies or the public (including improving the current regulation and reasonably viable nonregulatory actions), and an explanation why the planned regulatory action is preferable to the identified potential alternatives.

We submit this regulatory impact analysis to meet the requirements of Executive Order

12866. In doing so, we believe that this regulatory impact analysis also meets the regulatory assessment requirements of the Unfunded Mandates Reform Act of 1995 (UMRA). The regulatory analysis for Executive Order 12866 captures most of the analytical requirements of the UMRA. The UMRA asks for additional estimates of any disproportionate budgetary effects of the federal mandate upon any particular regions of the nation or particular State, local, or tribal governments, urban or rural or other types of communities, or particular segments of the private sector. The OCC does not expect the revised capital adequacy guidelines to have any disproportionate budgetary effect on any particular regions of the nation or particular State, local, or tribal governments, urban or rural or other types of communities, or particular segments of the private sector. The UMRA also requires the OCC to include estimates of the effect the rulemaking action may have on the national economy, if the OCC determines that such estimates are reasonably feasible and that such effect is relevant and material. We discuss the effect of the rule on the financial sector and the national economy in this regulatory analysis.

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EXECUTIVE SUMMARY

I. THE NEED FOR THE REGULATORY ACTION

Federal banking law directs federal banking agencies including the Office of the Comptroller of the Currency (OCC) to require banking organizations to hold adequate capital. The law authorizes federal banking agencies to set minimum capital levels to ensure that banking organizations maintain adequate capital. The law also gives federal banking agencies broad discretion with respect to capital regulation by authorizing them to also use any other methods that they deem appropriate to ensure capital adequacy.

Capital regulation seeks to address market failures that stem from several sources. Asymmetric information about the risk in a bank’s portfolio creates a market failure by hindering the ability of creditors and outside monitors to discern a bank’s actual risk and capital adequacy. Moral hazard creates market failure in which the bank’s creditors fail to restrain the bank from taking excessive risks because deposit insurance either fully or partially protects them from losses. Public policy addresses these market failures because individual banks fail to adequately consider the positive externality or public benefit that adequate capital brings to financial markets and the economy as a whole.

Capital regulations cannot be static. Innovation in and transformation of financial markets require periodic reassessments of what may count as capital and what amount of capital is adequate. Continuing changes in financial markets create both a need and an opportunity to refine capital standards in banking. The proposed revisions to U.S. risk-based capital rules, “Risk-Based Capital Guidelines; Capital Adequacy Guidelines; Capital Maintenance: Standardized Risk-Based Capital Rules” (Standardized Option), which we address in this impact analysis, provide a new option for determining risk-based capital for banking organizations not required to operate under “Risk-Based Capital Standards: Advanced Capital Adequacy Framework (Advanced Approaches). The Standardized Option and the Advanced Approaches reflect the implementation in the United States of the Basel Committee on Banking Supervision’s “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” (New Accord).

II. REGULATORY BACKGROUND

The proposed capital regulation examined in this analysis would apply to commercial banks and savings associations (collectively, banks). Three banking agencies, the OCC, the Board of Governors of the Federal Reserve System (Board), and the Federal Deposit Insurance Corporation (FDIC) regulate commercial banks, while the Office of Thrift Supervision (OTS) regulates all federally chartered and many state-chartered savings associations. Throughout this document, the four are jointly referred to as the federal banking agencies.

The New Accord comprises three mutually reinforcing “pillars” as summarized below.

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1. Minimum capital requirements (Pillar 1) The first pillar establishes a method for calculating minimum regulatory capital. It sets

new requirements for assessing credit risk and operational risk while generally retaining the approach to market risk as developed in the 1996 amendments to the 1988 Accord.

The New Accord offers banks a choice of three methodologies for calculating the capital

charge for credit risk. The first approach, called the Standardized Approach, essentially refines the risk-weighting framework of the 1988 Accord. The other two approaches are variations on an internal ratings-based (IRB) approach that leverages banks’ internal credit-rating systems: a “foundation” methodology whereby banks estimate the probability of borrower or obligor default, and an “advanced” approach whereby organizations also supply other inputs needed for the capital calculation. In addition, the new framework uses more risk-sensitive methods for dealing with collateral, guarantees, credit derivatives, securitizations, and receivables.

The New Accord also introduces an explicit capital requirement for operational risk.2

The New Accord offers banks a choice of three methodologies for calculating their capital charge for operational risk. The first method, called the Basic Indicator Approach, requires banks to hold capital for operational risk equal to 15 percent of annual gross income (averaged over the most recent three years). The second option, called the Standardized Approach, uses a formula that divides a bank’s activities into eight business lines, calculates the capital charge for each business line as a fixed percentage of gross income (12 percent, 15 percent, or 18 percent depending on the nature of the business, again averaged over the most recent three years), and then sums across business lines. The third option, called the Advanced Measurement Approaches (AMA), uses an institution’s internal operational risk measurement system to determine the capital requirement.

2. Supervisory review process (Pillar 2) The second pillar calls upon banking organizations to have an internal capital assessment

process and banking supervisors to evaluate each bank’s overall risk profile as well as its risk management and internal control processes. This pillar establishes an expectation that banks hold capital beyond the minimums computed under Pillar 1, including additional capital for any risks that are not adequately captured under Pillar 1. It encourages organizations to develop better risk management techniques for monitoring and managing their risks. Pillar 2 also charges supervisors with the responsibility to ensure that organizations using advanced Pillar 1 techniques, such as the Advanced IRB approach to credit risk and the AMA for operational risk, comply with the minimum standards and disclosure requirements of those methods, and take action promptly if capital is not adequate.

3. Market discipline (Pillar 3) The third pillar of the New Accord sets minimum disclosure requirements for banking

organizations. The disclosures, covering the composition and structure of the bank’s capital, the nature of its risk exposures, its risk management and internal control processes, and its capital

2 Operational risk is the risk of loss resulting from inadequate or failed processes, people, and systems or from external events. It includes legal risk, but excludes strategic risk and reputation risk.

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adequacy, are intended to improve transparency and strengthen market discipline. By establishing a common set of disclosure requirements, Pillar 3 seeks to provide a consistent and understandable disclosure framework that market participants can use to assess key pieces of information on the risks and capital adequacy of a bank.

B. U.S. implementation

The proposed Standardized Option rule seeks to improve the risk sensitivity of existing risk-based capital rules. The Standardized Option would be voluntary and available to banking organizations not subject to the Advanced Approaches rule. Any institution that is not an Advanced Approaches bank would be able to remain under the existing risk-based capital rules or elect to adopt the Standardized Option. The Standardized Option would:

1. Include a capital requirement for operational risk. 2. Use external credit ratings to risk weight sovereign, public sector entity, corporate,

and securitization exposures. 3. Use the risk weight of the appropriate sovereign to assign risk weights for

exposures to banks. 4. Use loan-to-value ratios to risk-weight residential mortgages. 5. Lower the risk weights for some retail exposures` and small loans to businesses. 6. Expand the range of credit risk mitigation techniques that are recognized for risk-

based capital purposes, including expanding the range of recognized collateral and eligible guarantors.

7. Increase the credit conversion factor for certain commitments with an original maturity of one year or less that are not unconditionally cancelable.

8. Revise the risk weights for securitization exposures and assess a capital charge for early amortizations in securitizations of revolving exposures.

9. Remove the 50 percent limit on the risk weight for certain derivative transactions. 10. Revise the risk-based capital treatment for unsettled and failed trades for securities,

foreign exchange, and commodities. 11. Expand the range of methodologies available to banking organizations for

measuring counterparty credit risk.

The Agencies would continue to reserve the authority to require banking organizations to hold additional capital where appropriate.

III. COST-BENEFIT ANALYSIS OF THE PROPOSED RULE A cost-benefit analysis considers the costs and benefits of a proposal as they relate to

society as a whole. The social benefits of a proposal are benefits that accrue directly to those subject to a proposal plus benefits that might accrue indirectly to the rest of society. Similarly, the overall social costs of a proposal are costs incurred directly by those subject to the rule and costs incurred indirectly by others. In the case of the Standardized Option, direct costs and benefits are those that apply to the banking organizations that are subject to the proposal.

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Indirect costs and benefits then stem from banks and other financial institutions that are not subject to the proposal, bank customers, and, through the safety and soundness externality, society as a whole.

The broad social and economic benefit that derives from a safe and sound banking system supported by vigorous and comprehensive supervision, including ensuring adequate capital, clearly dwarfs any direct benefits that might accrue to institutions adopting the Standardized Option. Similarly, the social and economic cost of any reduction in the safety and soundness of the banking system would dramatically overshadow any cost borne by banking organizations subject to the rule. The banking agencies are confident that the enhanced risk sensitivity of the proposed rule could allow banking organizations to more effectively achieve objectives that are consistent with a safe and sound banking system.

Beyond this societal benefit from maintaining a safe and sound banking system, we do not anticipate additional benefits outside of those accruing directly to the banking organizations that elect to adopt the Standardized Option. Because many factors besides regulatory capital requirements affect pricing and lending decisions, we do not expect the adoption or non-adoption of the Standardized Option to affect pricing or lending. Hence, we do not anticipate any costs or benefits affecting the customers or competitors of institutions adopting the Standardized Option. For these reasons, the cost and benefit analysis of the Standardized Option is primarily an analysis of the costs and benefits directly attributable to institutions that might elect to adopt its capital rules.

A. Organizations Affected by the Proposed Rule3 As of December 31, 2007, twelve banking organizations meet the criteria that would

require them to adopt the U.S. implementation of the New Accord’s advanced approaches. Removing those 12 mandatory Advanced Approaches institutions from the 7,415 FDIC-insured banking organizations active in December 2007 leaves 7,403 organizations that would be eligible to adopt the Standardized Option. Seven of the twelve mandatory Advanced Approaches institutions are national banks. Out of 1,421 banking organizations with national banks, 1,414 national banking organizations would thus be eligible to adopt the Standardized Option.

B. Benefits of the Proposed Rule

The proposed rule aims to enhance safety and soundness by improving the risk sensitivity of regulatory capital requirements. The proposed rule:

1. Enhances the risk sensitivity of capital charges. 2. Facilitates more efficient use of required bank capital. 3. Recognizes new developments in financial markets.

3 Unless otherwise noted, the population of banks and thrifts used in this analysis consists of all FDIC-insured institutions. Banking organizations are aggregated to the top holding company level.

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4. Mitigates potential distortions in minimum regulatory capital requirements between Advanced Approaches banking organizations and other banking organizations.

5. Better aligns capital and operational risk and encourages banking organizations to mitigate operational risk.

6. Enhances supervisory feedback. 7. Promotes market discipline through enhanced disclosure. 8. Preserves the benefits of international consistency and coordination achieved with

the 1988 Basel Accord. 9. Offers long-term flexibility to banking organizations by providing the ability to opt

in to the Standardized Approach.

C. Costs of the Proposed Rule As with any rule, the costs of the proposal include expenditures by banks and thrifts

necessary to comply with the new regulation and costs to the federal banking agencies of implementing the new rules. Because of a lack of cost estimates from banking organizations, the OCC found it necessary to use a scope-of-work comparison with the Advanced Approaches in order to arrive at a cost estimate for the Standardized Option. Based on this rough assessment, we estimate that implementation costs for the Standardized Option could range from $200,000 at smaller institutions to $5 million at larger institutions.

1. Costs to Banking Organizations Explicit costs of implementing the proposed rule at banking organizations fall into two

categories: setup costs and ongoing costs. Setup costs are typically one-time expenses associated with introducing the new programs and procedures necessary to achieve initial compliance with the proposed rule. Setup costs may also involve expenses related to tracking and retrieving data needed to implement the proposed rule. Ongoing costs are also likely to reflect data costs associated with retrieving and preserving data.

The total cost of the Standardized Option depends entirely on the number and size of

institutions that elect to adopt the voluntary rule. Obviously, if the number of institutions adopting the Standardized Option is zero, then the cost to banks will be zero. Based on comment letters and discussions with bank supervision staff, we sought to identify national banks that would be most likely to adopt the Standardized Option. Because one of the principal changes in the Standardized Option affects the risk weighting for residential mortgages, we selected national banks with significant mortgage holdings as the more likely adopters of the new rule. In particular, our list of more likely adopters includes national banks where 1-4 family first-lien mortgages comprise over 30 percent of all assets if the institution has less than $1 billion in assets and where the mortgage to asset ratio is over 20 percent at larger institutions. We also include the few national banks that do not meet the well-capitalized threshold for their risk based capital-to-assets ratio as of December 31, 2007. Using those criteria, we identified 113 national banks, which if they adopted the Standardized Option would result in a total cost to national banks of approximately $74 million. Over time, the Standardized Option may become more appealing to a larger number of banks. The total cost of the proposed rule would consequently increase to the extent that more institutions opt into the Standardized Option over time. At present, it is unclear how many national banks will ultimately elect to adopt the Standardized

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Option. The Standardized Option’s provision for an explicit charge for operational risk is another important factor that national banks will undoubtedly consider in assessing whether to adopt the Standardized Option. Although we are unable to estimate how many of our estimated adopters might be dissuaded from the Standardized Option because of an operational risk capital charge, we do believe that the explicit charge for operational risk could significantly reduce the number of likely adopters.4

2. Government Administrative Costs Like the banking organizations subject to new requirements, the costs to government

agencies of implementing the proposed rule also involve both startup and ongoing costs. Startup costs include expenses related to the development of the regulatory proposals, costs of establishing new programs and procedures, and costs of initial training of bank examiners in the new programs and procedures. Ongoing costs include maintenance expenses for any additional examiners and analysts needed to regularly apply the new supervisory processes. In the case of the Standardized Option, because modest changes to Call Reports will capture most of the rule changes, these ongoing costs are likely to be minor.

OCC expenditures fall into three broad categories: training, guidance, and supervision.

Training includes expenses for workshops and other training courses and seminars for examiners. Guidance expenses reflect expenditures on the development of Standardized Option guidance. Supervision expenses reflect organization-specific supervisory activities. We estimate that OCC expenses for the Standardized Option will be approximately $4.3 million through 2008. We also expect expenditures of $1 million per year between 2009 and 2011. Applying a five percent discount rate to future expenditures, past expenses ($4.3 million) plus the present value of future expenditures ($2.7 million) equals total OCC expenditures of $7 million on the Standardized Option.

3. Total Cost Estimate of Proposed Rule The OCC’s estimate of the total cost of the proposed rule includes expenditures by

banking organizations and the OCC from the present through 2011. Based on our estimate that approximately 113 national banks will adopt the Standardized Option at a cost to each institution of between $200,000 and $5 million depending on the size of the institution, we estimate that national banks will spend approximately $74 million on the Standardized Option. Combining expenditures provides an estimate of $81 million for the total cost of the proposed rule for the OCC and national banks.

IV. ANALYSIS OF BASELINE AND ALTERNATIVES In order to place the costs and benefits of the proposed rule in context, Executive Order

12866 requires a comparison between the proposed rule, a baseline of what the world would look 4 If the Advanced Measurement Approaches (AMA) option for operational risk is available as part of the Standardized Option, we believe that its considerable startup requirements and accompanying costs would dissuade almost all institutions with less than $10 billion from pursuing the AMA operational risk option.

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like without the proposed rule, and a reasonable alternative to the proposed rule. In this regulatory impact analysis, we analyze one baseline and one alternative to the proposed rule. The baseline considers the possibility that the proposed Standardized Option rule is not adopted and current capital standards continue to apply.

The baseline scenario appears in this analysis in order to estimate the effects of adopting

the proposed rule relative to a hypothetical regulatory regime that might exist without the Standardized Option. Because the baseline scenario considers costs and benefits as if the proposed rule never existed, we set the costs and benefits of the baseline scenario to zero. Obviously, banking organizations face compliance costs and reap the benefits of a well-capitalized banking system even under the baseline. However, because we cannot quantify these costs and benefits, we normalize the baseline costs and benefits to zero and estimate the costs and benefits of the proposed rule and alternative as deviations from this zero baseline.

1. Baseline Scenario: Current capital standards based on the 1988 Basel Accord

continue to apply. Description of Baseline Scenario

Under the Baseline Scenario, current capital rules would continue to apply to all banking

organizations in the United States that are not subject to the U.S. implementation of the Advanced Approaches. Under this scenario, the United States would not adopt the proposed Standardized Option but the implementation of the Advanced Approaches final rule would continue.

Change in Benefits: Baseline Scenario Staying with current capital rules instead of adopting the Standardized Option proposal

would eliminate the nine benefits of the proposed rule listed above. Under the baseline, banking organizations not subject to the Advanced Approaches would not be given the option of voluntarily selecting the Standardized Option. Institutions that would have adopted the Standardized Option would not be able to take advantage of the enhanced risk sensitivity of its capital charges and the more efficient use of bank capital that implies.

Without the Standardized Option, an institution would have to choose between the Advanced Approaches and the status quo. The baseline without the Standardized Option would leave a level playing field for all the non-core banks. However, the absence of an opportunity to mitigate potential distortions in minimum required capital would likely diminish this benefit in the eyes of an institution concerned about potential distortions created by the implementation of the Advanced Approaches.

Changes in Costs: Baseline Scenario

Continuing to use current capital rules eliminates the benefits and the costs of adopting the proposed rule. As discussed above, under the proposed rule we estimate that organizations would spend up to $74 million on implementation-related expenditures. Retaining current

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capital rules would eliminate any costs associated with the proposed rule, even though banking organizations would only incur those costs if they elected to do so.

2. Alternative: Require all U.S. banking organizations not subject to the Advanced Approaches rule to adopt the Standardized Option.

Description of Alternative

The only change between the proposed rule and the alternative is that adoption of the proposed rule would be mandatory under the alternative rather than voluntary. Under this alternative, the provisions of the proposed rule would remain intact and apply to all national banks that are not subject to the Advanced Approaches rule, i.e., mandatory Advanced Approaches institutions and those institutions that elect to adopt the Advanced Approaches framework.

Change in Benefits: Alternative

Because there are no changes to the elements of the proposed rule under the alternative, the list of benefits remains the same. Among these benefits, only one benefit is lost by making the proposed rule mandatory: the benefit derived from the fact that the proposed rule is voluntary. As for the benefits relating to the enhanced risk sensitivity of capital charges, because adoption of the Standardized Option is mandatory under the alternative, more banks will be subject to the Standardized Option provisions and the aggregate level of benefits will be higher. Because we estimate that 113 national banks would adopt the Standardized Option voluntarily, the difference in the aggregate benefit level could be considerable.

Changes in Costs: Alternative

Clearly the most significant drawback to the alternative is the dramatically increased cost of applying a new set of capital rules to almost all U.S. banking organizations. Under the alternative, direct costs would increase for every U.S. banking organization that would have elected to continue to use current capital rules under the proposed rule. The cost estimate for the alternative is the total cost estimate for a 100 percent adoption rate of the Standardized Option. With 1,414 national banking organizations eligible for the Standardized Option, we estimate that the cost to national banking organizations of the alternative is approximately $740 million. The actual cost may be somewhat less depending on the number of national banks that elect to adopt the Advanced Approaches rule, but it is much greater than our cost estimate of $74 million for the proposed rule.

3. Overall Comparison of Proposed Rule with Baseline and Alternative

The New Accord and its U.S. implementation seek to incorporate risk measurement and risk management advances into capital requirements. Risk-sensitive capital requirements are integral to ensuring an adequate capital cushion to absorb financial losses at financial institutions. In implementing the Standardized Option in the United States, the agencies’ intent

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is to enhance risk sensitivity while maintaining a regulatory capital regime that is as rigorous as the current system. Total capital requirements under the Standardized Option, including capital for operational risk, will better allocate capital in the system. This will occur regardless of whether the minimum required capital at a particular institution is greater or less than it would be under current capital rules.

The objective of the proposed rule is to enhance the risk sensitivity of capital charges for institutions not subject to the Advanced Approaches rule. The proposal also seeks to mitigate any potential distortions in minimum regulatory capital requirements that the implementation of the Advanced Approaches rule might create between large and small banking organizations. Like the Advanced Approaches rule, the anticipated benefits of the Standardized Option proposal are difficult to quantify in dollar terms. Nevertheless, the OCC believes that the proposed rule provides benefits associated with enhanced risk sensitivity and preserves the safety and soundness of the banking industry and the security of the Federal Deposit Insurance system. To offset the costs of the proposed rule, its voluntary nature offers regulatory flexibility that will allow institutions to adopt the Standardized Option on a bank-by-bank basis when an institution’s anticipated benefits exceed the anticipated costs of adopting this regulation.

The banking agencies are confident that the proposed rule could serve to strengthen institutions electing to adopt the Standardized Option while the safety and soundness of institutions electing to forgo the Standardized Option and the Advanced Approaches rule will not diminish. On the basis of our analysis, we believe that the benefits of the proposed rule are sufficient to offset the costs of implementing the proposed rule. However, with safety and soundness secure under either capital rule, we believe it is best to make the proposed rule voluntary in order to let each national bank decide whether it is in that institution’s best interest to adopt the Standardized Option. This will help to ensure that the costs associated with implementation of the Standardized Option do not rise precipitously and outweigh the benefits. Because adoption is voluntary, the proposed rule offers an improvement over the baseline scenario and the alternative. The proposed rule offers an important degree of flexibility unavailable with either the baseline or the alternative. The baseline does not give banking organizations a way into the Standardized Option and the alternative does not offer them a way out. The alternative for mandatory adoption would compel most banking organizations to follow a new set of capital rules and require them to undertake the time and expense of adjusting to these new rules. The proposed rule offers a better balance between costs and benefits than either the baseline or the alternative. Overall, the OCC believes that the benefits of the proposed rule justify its potential costs.

End of Executive Summary

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REGULATORY IMPACT ANALYSIS

I. THE NEED FOR THE REGULATORY ACTION

A. Statutory Authority for Capital Regulation

Federal banking law5 directs federal banking agencies including the Office of the Comptroller of the Currency (OCC) to require banking organizations to hold adequate capital. The law authorizes federal banking agencies to set minimum capital levels to ensure that banking organizations maintain adequate capital. The law also gives federal banking agencies broad discretion with respect to capital regulation by authorizing them to also use any other methods that they deem appropriate to ensure capital adequacy. Congress has directed the federal banking agencies to apply consistent accounting standards in determining regulatory capital. Specifically, 12 USC 1831n(b), which is titled "Uniform accounting of capital standards", states that "each appropriate federal banking agency shall maintain uniform accounting standards to be used for determining compliance with statutory or regulatory requirements of depository institutions." Further, 12 USC 1831n(c) mandates that the agencies report annually to Congress on any capital differences with explanations of the reasons for any discrepancies.

As the primary supervisor of national banks, the OCC oversees the capital adequacy of national banks and federal branches of foreign banking organizations. If banks under the OCC’s supervision fail to maintain adequate capital, federal law authorizes the OCC to take enforcement action up to and including placing the bank in receivership, conservatorship, or requiring its sale, merger, or liquidation.

B. Capital Regulation Seeks to Address Market Failures Capital regulation seeks to address market failures that stem from the unique structure

and role of banks in the financial system. These market failures tend to create incentives for managers of banking organizations to hold less capital than is optimal from a broader societal perspective. Managers, in responding rationally to those distorted incentives, may try to hold capital that may not adequately account for the institution’s exposure to risk. This in turn can

5 In relevant part, 12 U.S.C. Section 3907 provides:

(a)(1) Each appropriate Federal banking agency shall cause banking institutions to achieve and maintain adequate capital by establishing minimum levels of capital for such banking institutions and by using such other methods as the appropriate Federal banking agency deems appropriate.

(2) Each appropriate Federal banking agency shall have the authority to establish such minimum level of capital for a banking institution as the appropriate Federal banking agency, in its discretion, deems to be necessary or appropriate in light of the particular circumstances of the banking institution.

(b)(1) Failure of a banking institution to maintain capital at or above its minimum level as established pursuant to subsection (a) of this section may be deemed by the appropriate Federal banking agency, in its discretion, to constitute an unsafe and unsound practice within the meaning of section 1818 of this title. ***

*****

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lead banking organizations to hold a level of capital that differs from a socially optimal level.6 The market failures creating these perverse incentives stem from several sources.

Banking faces a market failure attributable to asymmetric information. This arises

because of the difference between the information a banking organization has about the risk of its asset portfolio and the information available to outside monitors of the institution, such as depositors and creditors. If outside monitors and inside managers shared the same information about the true amount of risk an institution had assumed, then through financial markets the outsider would be able to compel the organization to hold capital at a level commensurate with its level of risk. This information asymmetry operates to some extent in virtually all firms. However, it is particularly a problem in banking because of the opaque nature of most lending relationships; although borrowers are willing to share information about their finances with their lenders to gain financing, they typically will not share such private information with others. Furthermore, even if borrowers were willing to share this information with outsiders, the cost to outsiders of gathering and evaluating this information for each of an institution’s borrowers would be prohibitive. Because outside monitors lack complete information about the risk of the banking organization’s portfolio, they may not induce the organization to hold adequate amounts of capital. If outside monitors underestimate the amount of risk, they will expect too little capital from the institution. If they overestimate the risk, they will demand excessive amounts of capital.

Moral hazard problems related to deposit insurance could exacerbate the market failure

created by asymmetric information. In banking, moral hazard refers to the incentive financial institutions have to accept greater risks in pursuit of higher returns when they do not bear the full cost of losses associated with risky ventures. Because the Federal Deposit Insurance Corporation (FDIC) insures deposits, the FDIC, rather than depositors, bears some of the cost of taking those risks. Thus, even if banking markets were not subject to asymmetric information problems, depositors would expend less effort to monitor capital levels and to constrain risk-taking than they would in the absence of deposit insurance. Deposit insurance may also reduce bankers’ concerns about jeopardizing depositors’ funds, if they recognize that insurance protects the depositor. Troubled institutions may be particularly willing to take greater risks in an effort to recover by pursuing opportunities along the risk-return frontier that promise higher returns but at much greater risk. Moral hazard problems such as these likely contributed to the savings and loan crisis in the 1980s.7

These individual market failures might be of less concern if not for the presence of

externalities in banking. The failure of an individual banking organization can have external

6 Several factors will determine a banking organization’s ultimate level of capital. In determining capital levels, banking institutions must begin with the regulatory minimum. Because of Prompt Corrective Action, falling below the regulatory minimum has serious consequences. Beyond the regulatory minimum, institution management will typically add capital to provide an appropriate buffer to the regulatory minimum. A banking organization will also seek a capital level that is consistent with achieving the institution’s target credit rating from credit rating agencies. For further discussion of the drivers of capital levels, see Chris Matten, Managing Bank Capital, Second Edition, New York: John Wiley & Sons, 2000, p. 26. 7 For one discussion of moral hazard and the savings and loan crisis, see Elijah Brewer III and Thomas H. Mondschean, “Ex ante Risk and Ex Post Collapse of S&Ls in the 1980s”, Economic Perspectives, Federal Reserve Bank of Chicago, July/August 1992, pp. 2 – 12.

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effects on depositors, borrowers, and the local economy. Weakness at one institution may affect how the market perceives the health of other banking organizations and lead to pressures on those institutions. Furthermore, a loss in confidence in the banking system can impose considerable costs on the macroeconomy. Adequate capital, therefore, conveys important benefits that extend beyond an individual banking organization and affects the ability of the banking system as a whole to absorb unexpected losses. Whereas each institution’s capital protects it from losses, the ability of each individual institution to absorb losses strengthens the collective ability of the banking system to absorb losses like combining individual wires to form a stronger cable. A banking organization does not receive compensation for its contribution to the overall strength of the banking system. Because banking organizations do not receive compensation for the external benefit of their capital, they are likely to hold less than a socially optimal level of capital in the absence of capital requirements.

To sum up, asymmetric information about the risk in a bank’s portfolio creates a market

failure by hindering the ability of creditors and outside monitors to discern a bank’s actual risk and capital adequacy. Moral hazard creates market failure in which a bank’s creditors fail to restrain the bank from taking excessive risks because deposit insurance either fully or partially protects them from losses. These market failures engender concerns that public policy seeks to address because of externalities inherent in the banking system. Individual banks’ decisions regarding their own capital levels fail to adequately consider the positive externality that adequate capital brings to the banking system. Ensuring adequate capital through regulation seeks to address these market failures and produce the positive externality that adequate capital brings to financial markets and the economy as a whole.

Capital regulations that address the market failures described above cannot be static.

Innovation in and transformation of financial markets require periodic reassessments of what may count as capital and what amount of capital is adequate. For example, after financial market turbulence in the 1980s, the implementation of new capital standards based on the 1988 Basel Accord introduced significant changes to the definition of what constitutes both capital and capital adequacy and strove to standardize capital requirements across international boundaries. Continuing changes in financial markets create an opportunity to refine capital standards in banking. The proposed revisions to U.S. risk-based capital rules, “Risk-Based Capital Guidelines; Capital Adequacy Guidelines; Capital Maintenance: Standardized Risk-Based Capital Rules” (Standardized Option), which we address in this impact analysis, provide a new option for determining risk-based capital for banking organizations that would not be required to operate under “Risk-Based Capital Standards: Advanced Capital Adequacy Framework (Advanced Approaches). The Standardized Option and the Advanced Approaches rule reflect the implementation in the United States of the Basel Committee on Banking Supervision’s “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” (New Accord).

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II. REGULATORY BACKGROUND

A. The regulated community The capital regulation examined in this analysis applies to commercial banks and savings

associations (collectively, banks). Three banking agencies, the OCC, the Board of Governors of the Federal Reserve System (Board), and the Federal Deposit Insurance Corporation (FDIC) regulate commercial banks, while the Office of Thrift Supervision (OTS) regulates all federally chartered and many state-chartered savings associations. The OCC is the primary supervisor of national banks. The Board supervises state-chartered banks that are members of the Federal Reserve System, and the FDIC supervises state-chartered banks that are not members of the Federal Reserve System. Throughout this document, the four regulators are jointly referred to as the federal banking agencies.8

B. Capital adequacy regulation before 1988

The assessment of capital adequacy has been a cornerstone of bank and thrift regulation since the earliest days of the national banking system. In 1864, the National Banking Act set capital requirements for each national bank based on the population of its service area. Around the start of the 20th Century, supervisors began focusing on capital-to-deposit ratios. In succeeding years, as the demand for loans outstripped the supply of deposits and banking organizations turned to other sources of funding, capital-to-assets ratios gradually supplanted capital-to-deposits ratios as the preferred measure of capital adequacy. By the 1950s, supervisors had begun to study ways of adjusting assets for risk in order to compute capital-to-risk-weighted-assets ratios, but these early efforts did not gain wide acceptance.

Throughout this period, supervisors employed a subjective, case-by-case approach to

assessing capital adequacy. Regulators felt that reducing capital adequacy to a formula would preclude the supervisory judgments needed to evaluate the many factors influencing an institution's ability to sustain losses. This view changed in the 1970s and early 1980s when a decline in average capital ratios and a series of high-profile bank and thrift failures convinced supervisors of the need to set a regulatory floor on capital.

In 1981, the federal banking agencies introduced the first explicit minimum capital ratio:

a “leverage ratio” of primary capital (consisting mainly of equity and loan loss reserves) to total assets. Initially there were some differences in the thresholds set by the different agencies, but by 1985 they had agreed on a uniform minimum leverage ratio of 5.5 percent for all banking organizations. The banking agencies considered it “unsafe and unsound” for institutions to operate with leverage ratios below 3 percent and subjected such institutions to enforcement action. Legislation strengthened the link between capital ratios and supervisory intervention in the aftermath of the thrift crisis of the late 1980s.

During the 1980s, regulators in the United States and other industrialized countries

became concerned that simple capital-to-assets ratios required too much capital for safe assets such as Treasury securities and not enough for riskier assets. Another concern was that the rules did not require any capital for banking organizations’ rapidly growing portfolios of off-balance- 8 The term bank will refer to any commercial bank or thrift regulated by one of the federal banking agencies.

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sheet exposures. These concerns led to the development of the risk-based capital framework that the Basel Committee on Banking Supervision9 adopted in 1988 and implemented at the end of 1992 (the 1988 Accord). This 1988 Accord serves as the basis for current U.S. capital regulations. The 1988 Accord required that internationally active banking organizations adopt the new capital rules, but some countries, including the United States, chose to apply the 1988 Basel framework to all banks and thrifts.

C. The 1988 Accord and the New Accord

Drafters of the 1988 Accord designed capital rules to create a level playing field for institutions in different countries and to strengthen the soundness and stability of the international banking system. The 1988 Accord sought to level the playing field in international banking by enhancing international consistency and to strengthen the international banking system by more closely aligning required capital with risk. The 1988 Accord consists of three basic elements: a target minimum capital ratio of 8 percent; a definition of the capital instruments to comprise the numerator of the capital-to-risk-weighted-assets ratio; and a system of risk weights for calculating the denominator of the ratio.

As implemented in the United States, the risk-weighting criteria of the 1988 Accord

divide credit exposures into four basic categories and assign a fixed risk weight to each category. The four categories and their respective risk weights are (1) cash and sovereign exposures with a risk weight of 0 percent, (2) interbank and certain other relatively low-risk exposures with a risk weight of 20 percent, (3) residential mortgages with a risk weight of 50 percent, and (4) all other exposures (including unsecured corporate exposures), which carry a 100 percent risk weight. A risk weight of 100 percent means that the calculation of risk-weighted assets includes the exposure at its full value, which translates to a capital requirement equal to 8 percent of the amount of the exposure. Off-balance-sheet exposures convert into “credit-equivalent amounts” by applying specified “credit conversion factors” to their notional amounts and then risk-weighting them in the same way as on-balance-sheet exposures.

The 1988 Accord also specifies what instruments may count toward the capital

requirement. The Accord requires that equity capital (common and non-cumulative preferred shares) and disclosed reserves cover at least half of the target ratio. Qualifying hybrid capital instruments, subordinated debt, and general, undisclosed, and revaluation reserves may cover the remainder subject to various limitations.

The acknowledged central focus of the original 1988 Accord was credit risk. Minimum

required capital did not depend directly on the other types of risk that banks and thrifts must manage, such as interest-rate risk, liquidity risk, or operational risk, although the level of required capital provided de facto coverage for such risks. Amendments to the Accord in 1996 added explicit capital charges for interest-rate related instruments and equities in the trading book; as well as charges for foreign exchange risk and commodity risk throughout the institution. 9 The Basel Committee on Banking Supervision includes representatives from the central banks and other authorities with bank supervisory responsibilities in the G-10 countries. Current member countries are Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States.

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The 1988 Accord had several beneficial effects. At a time when supervisors viewed

capital ratios as too low, it had a positive effect on capital levels: during the 1988-1992 transition period, the capital ratios of nearly all internationally active banking organizations increased substantially. The 1988 Accord also fostered greater competitive equity among internationally active banking organizations and introduced an era of improved information sharing and coordination among national supervisors. It also reduced incentives for institutions to avoid liquid, low-risk assets such as Treasury securities, which had capital requirements far in excess of their actual credit risk under the preceding regime of uniform leverage requirements. Perhaps most importantly, it created a mechanism by which bank capital requirements could reflect, at least to some extent, differences in risk across institutions and over time.

With the passage of time, however, it became clear that the 1988 Accord was not

providing a sufficiently accurate measure of capital adequacy. It introduced only a small degree of risk-sensitivity into risk weightings, ignoring an important dimension of risk: the difference between more and less creditworthy counterparties within a given asset class. It did not provide adequate recognition of risk mitigation techniques, probably discouraging institutions from using such techniques and so detracting from the safety and soundness of the banking system. The rigidity of the risk-weighting framework tended to encourage transactions whose sole benefit was regulatory capital relief. Finally, the 1988 Accord could not anticipate financial innovations such as securitization, which shifts most of the notional amount of a credit exposure off the balance sheet while retaining most of the credit risk. In all of these areas, internal systems for measuring risk at many banking organizations have outstripped the 1988 Accord.

Research and experience suggest that risk-based capital rules based on the 1988 Accord

may not always adequately reflect differences in credit risk among bank assets, especially with respect to large internationally active financial institutions. In some cases the current rules require too much capital in relation to risk. In other cases, the rules require too little capital. This situation gives rise to a number of potential effects, including misaligned private risk-taking incentives.

The New Accord aims to maintain and extend the benefits of the 1988 Accord while

addressing these signs of age. It comprises three mutually reinforcing “pillars.”10 The first pillar of The New Accord establishes a method for calculating minimum regulatory capital. It sets new requirements for assessing credit risk and operational risk while retaining the approach to market risk as developed in the 1996 amendments to the 1988 Accord. It includes an extensive set of qualitative requirements designed to help ensure that the internal measurement and control systems used to determine capital adequacy for credit risk and operational risk are sound.

The New Accord offers banks a choice of three methodologies for calculating the capital

charge for credit risk. The first approach, called the Standardized Approach, essentially refines the risk-weighting framework of the 1988 Accord. The other two approaches are variations on an internal ratings-based (IRB) approach that leverages banks’ internal credit-rating systems: a “foundation” methodology whereby banks estimate the probability of borrower or obligor 10 The reference document for the New Accord is “International Convergence of Capital Measurement and Capital Standards: A Revised Framework,” Basel Committee on Banking Supervision, June 2004.

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default, and an “advanced” approach whereby organizations also supply other inputs needed for the capital calculation. In addition, the new framework uses more risk-sensitive methods for dealing with collateral, guarantees, credit derivatives, securitizations, and receivables.

The New Accord also introduces an explicit capital requirement for operational risk.11

The New Accord offers banks a choice of three methodologies for calculating their capital charge for operational risk. The first method, called the Basic Indicator Approach, requires banks to hold capital for operational risk equal to 15 percent of annual gross income (averaged over the most recent three years). The second option, called the Standardized Approach, uses a formula that divides a bank’s activities into eight business lines, calculates the capital charge for each business line as a fixed percentage of gross income (12 percent, 15 percent, or 18 percent depending on the nature of the business, again averaged over the most recent three years), and then sums across business lines. The third option, called the Advanced Measurement Approaches (AMA), uses an institution’s internal operational risk measurement system to determine the capital requirement.

The second pillar calls upon banking organizations to have an internal capital assessment

process and for banking supervisors to evaluate each bank’s overall risk profile as well as its risk management and internal control processes. This pillar establishes an expectation that organizations hold capital beyond the minimums computed under Pillar 1, including additional capital for any risks that are not adequately captured under Pillar 1. It also encourages organizations to develop better risk management techniques for monitoring and managing their risks.

The third pillar sets minimum disclosure requirements for banking organizations. The

disclosures, covering the composition and structure of the institution’s capital, the nature of its risk exposures, its risk management and internal control processes, and its capital adequacy, are intended to improve transparency and strengthen market discipline. By establishing a common set of disclosure requirements, Pillar 3 seeks to provide a consistent and understandable disclosure framework that market participants can use to assess key pieces of information on the risks and capital adequacy of a bank.

D. The Standardized Option

As the rulemaking process moved forward for the Advanced Approaches rule, the banking agencies determined that applying greater risk sensitivity to some general banking organizations could also be beneficial. In particular, the agencies considered the possibility of enhancing the risk sensitivity of capital calculations for residential mortgages, an important component of the asset portfolios of many smaller financial institutions. The banking agencies then developed the Standardized Option proposal to improve the risk sensitivity of existing risk-based capital rules as they would apply to institutions that do not adopt the Advanced Approaches. The proposed revisions are summarized below.

11 Operational risk is the risk of loss resulting from inadequate or failed processes, people, and systems or from external events. It includes legal risk, but excludes strategic risk and reputation risk.

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1. Scope

Adoption of the Standardized Option would be optional under the proposed rule. This rule would be available to any banking organization that is not subject to the Advanced Approaches rule. Any bank that is not a mandatory Advanced Approaches bank would be able to remain under existing risk-based capital rules or voluntarily adopt the Standardized Option. However, a bank that opts in would have to adopt the Standardized Option in its entirety. Although the proposed rule does not preclude an institution from dropping out of the Standardized Option after adoption, such a decision would first require notification of the institution’s banking supervisor. While banks would have this flexibility, a banking organization’s primary federal supervisor could require the institution to use either existing capital rules or the Standardized Option if the supervisor deems that a particular capital rule is appropriate in light of the banking organization’s asset size, level of complexity, risk profile, or scope of operations.

2. Proposed Revisions The proposed Standardized Option would: Include a capital requirement for operational risk. Currently there is no explicit capital

charge for operational risk. Although capital under the 1988 Accord implicitly covered non-credit-related risks such as operational risk, its risk weights did not explicitly reflect this aspect of a bank’s risk profile. Under the proposed rule, banks will use the Basic Indicator Approach, which requires banks to hold capital for operational risk equal to 15 percent of annual gross income (averaged over the most recent three years).12

Use external credit ratings to risk weight sovereign, public sector entity, corporate, and

securitization exposures, and use the risk weight of the appropriate sovereign to assign risk weights for exposures to banks and eligible securities firms. Existing risk-based capital rules permit the use of external credit ratings issued by a nationally recognized statistical rating organization (NRSRO) to assign risk weights to recourse obligations, direct credit substitutes, residual interests (other than a credit-enhancing interest-only strip), and asset- and mortgage-backed securities. The proposal would expand the use of external credit ratings to determine risk weights for certain exposures that are externally rated by an NRSRO.

Expand the range of credit risk mitigation techniques that are recognized for risk-based

capital purposes, including expanding the range of recognized collateral and eligible guarantors. The existing risk-based capital rules recognize limited types of collateral.13 The proposal would revise the list of recognized collateral to include a broader array of externally rated, liquid, and readily marketable financial instruments. It would also expand the list of

12 The proposed rule asks for comments as to whether banks should be able to use the Advanced Measurement Approaches (AMA) for operational risk, which uses a bank’s internal operational risk measurement system to determine the capital requirement. 13 Cash on deposit; securities issued or guaranteed by central governments of the Organisation for Economic Co-operation and Development (OECD) countries; securities issued or guaranteed by the U.S. government or its agencies; U.S. government-sponsored entity securities; and securities issued by certain multilateral lending institutions or regional development banks.

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eligible guarantors14 by recognizing entities that have long-term senior debt (without credit enhancement) rated at least investment grade by an NRSRO or, in the case of a sovereign, an issuer rating that is at least investment grade.

Use loan-to-value ratios to risk weight residential mortgages. The existing capital rules

apply a 50 percent risk weight to performing, prudently underwritten single-family mortgages. If a single-family mortgage does not meet this standard, it is risk weighted at 100 percent. The proposal would assign risk weights for traditional and non-traditional single-family mortgages based on the loan-to-value (LTV) after consideration of private mortgage insurance (PMI). The proposal would also include an additional charge on the commitment portion of a mortgage with a negative amortization feature.

Increase the credit conversion factor for certain commitments with an original maturity

of one year or less that are not unconditionally cancelable. Currently, banking organizations extending commitments with an original maturity of one year or less or unconditionally cancellable commitments are not required to maintain risk-based capital against the credit risk inherent in these exposures. The proposal would assign a 20 percent credit conversion factor (CCF) for all short-term commitments that are not unconditionally cancellable.15 This would not apply to commitments to originate one-to-four-family residential mortgage loans that are provided in the ordinary course of business.

Revise the risk weights for securitization exposures and assess a capital charge for early

amortizations in securitizations of revolving exposures. The existing capital rules do not assess risk-based capital for risks associated with early amortization of securitizations of revolving credits, such as credit card receivables. The proposal would apply an approach based on excess spread to all revolving securitizations with early amortization features.

Remove the 50 percent limit on the risk weight for certain derivative transactions. The

existing risk-based capital rules permit banks to apply a maximum 50 percent risk weight to the credit equivalent amount of certain derivative contracts. The proposal would remove the 50 percent risk weight limit for those derivative contracts.

The proposed rule would also revise the risk-based capital treatment for unsettled and

failed trades for securities, foreign exchange, and commodities, and expand the range of methodologies available to banking organizations for measuring counterparty credit risk.

As with any proposal relating to regulatory capital, the federal banking agencies would

continue to reserve the authority to require banking organizations to hold additional capital where the agencies deem appropriate.

14 Presently, the recognition of third party guarantees is limited to guarantees provided by central governments of OECD countries, U.S. government and government-sponsored entities, public-sector entities in OECD countries, multilateral lending institutions and regional development banks, depository institutions and qualifying securities firms in OECD countries, depository institutions in non-OECD countries (short-term claims), and central governments of non-OECD countries (local currency exposures only). 15 Commitments that are unconditionally cancellable would retain a zero percent CCF.

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III. COST-BENEFIT ANALYSIS OF THE PROPOSED RULE In order to place the costs and benefits of the proposed rule in context, Executive Order

12866 requires a comparison between the proposed rule, a baseline of what the world would look like without the proposed rule, and a reasonable alternative to the proposed rule. The baseline considers the possibility that the proposed Standardized Option is not adopted and current capital standards continue to apply.

A cost-benefit analysis considers the costs and benefits of a proposal as they relate to

society as a whole. The social benefits of a proposal are benefits that accrue directly to those subject to a proposal plus benefits that might accrue indirectly to the rest of society. Similarly, the overall social costs of a proposal are costs incurred directly by those subject to the rule and costs incurred indirectly by others. In the case of the Standardized Option, direct costs and benefits are those that apply to the banking organizations that are subject to the proposal. Indirect costs and benefits then stem from banks and other financial institutions that are not subject to the proposal, bank customers, and, through the safety and soundness externality, society as a whole.

The broad social and economic benefit that derives from a safe and sound banking system supported by vigorous and comprehensive banking supervision, including ensuring adequate capital, clearly dwarfs any direct benefits that might accrue to institutions adopting the Standardized Option. Similarly, the social and economic cost of any reduction in the safety and soundness of the banking system would dramatically overshadow any cost borne by banking organizations subject to the rule. The banking agencies are confident that the enhanced risk sensitivity of the proposed rule could allow banking organizations to more effectively achieve objectives that are consistent with a safe and sound banking system. Ensuring the safety and soundness of the banking system is the primary objective of the OCC and a safe and sound banking system in turn safeguards federal deposit insurance funds.

Capital regulation is but one component of the regulatory supervision that buttresses our banking industry. This fact is made most apparent by the CAMELS rating system used by supervisory agencies to monitor conditions at banking organizations.16 The acronym CAMELS refers to the six components of an institution’s condition that examiners use to assess an institution. These six components are Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity to risk. Examiners assign an institution a CAMELS rating at the end of an exam and disclose these ratings to senior bank management and appropriate supervisory personnel. Thus, while assessing capital adequacy is an important component of supervision, it is but one facet of a broader supervisory process designed to protect the safety and soundness of the banking system.

Comprehensive supervision, as exemplified by the CAMELS assessment, will help address the potential problems with capital gamesmanship that might emerge with any change to regulatory capital rules. For instance, supervision will help to deal with institutions that might be tempted to switch in and out of the Standardized Option when it best suits them -- so called cherry picking. The OCC retains the authority for broad supervisory oversight regarding 16 For a description of CAMELS ratings, see Jose A. Lopez, “Using CAMELS Ratings to Monitor Bank Conditions,” Federal Reserve Bank of San Francisco, Economic Letter, #99-19, June 11, 1999.

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minimum capital levels and other aspects of bank management. A broad range of formal and informal enforcement tools are available to support the OCC’s supervisory oversight. Supervision, coupled with enforcement authority serves to address a broad range of potential problems that arise in banking organizations, not just those related to ensuring capital adequacy.17

Beyond the societal benefit from maintaining a safe and sound banking system, we do not anticipate additional benefits outside of those accruing directly to the banking organizations that elect to adopt the Standardized Option. Because many factors besides regulatory capital requirements affect pricing and lending decisions, we do not expect the adoption or non-adoption of the Standardized Option to affect pricing or lending. Hence, we do not anticipate any costs or benefits affecting the customers or competitors of institutions adopting the Standardized Option. For these reasons, the cost and benefit analysis of the Standardized Option is primarily an analysis of the costs and benefits directly attributable to institutions that might elect to adopt the Standardized Option capital rules.

As was true with the regulatory impact analysis of the Advanced Approaches implementation, cost and benefit analysis of changes in minimum capital requirements entail considerable measurement problems. On the cost side, it can be difficult to attribute particular expenditures because institutions would likely incur some of these costs as part of their ongoing efforts to improve risk measurement and management systems. On the benefits side, measurement problems are even greater because the benefits of the Standardized Option are more qualitative than quantitative. Measurement problems exist even with an apparently measurable effect such as lower minimum capital because lower minimum requirements do not necessarily mean lower capital. Healthy banking organizations generally hold capital well above regulatory minimums for a variety of reasons and the effect of reducing the regulatory minimum is uncertain and likely to vary across regulated institutions.

A. Organizations Affected by the Proposed Rule18 After the U.S. implementation of the Advanced Approaches, the proposed

implementation of the Standardized Option in the United States would create a trifurcated system of capital requirements. A relatively small group of mandatory and opt-in Advanced Approaches organizations would be subject to capital requirements based on The New Accord’s Advanced IRB approach and AMA. A second group of indeterminate size would opt to adopt the Standardized Option, and the remainder would use current capital rules.

As of December 31, 2007, 12 banking organizations meet the criteria that would require

them to adopt the U.S. implementation of the New Accord’s advanced approaches. Removing

17 Informal enforcement tools include: supervisory letters and directives, special examinations, notices of deficiency and requests for safety and soundness compliance plans. Formal enforcement tools include formal written agreements (including supervisory agreements), temporary cease and desist orders, permanent cease and desist orders, temporary suspensions, removal and prohibition orders, civil money penalties, prompt corrective action directives, and a variety of other agency actions and court orders. 18 Unless otherwise noted, the population of banks and thrifts used in this analysis consists of all FDIC-insured institutions. Banking organizations are aggregated to the top holding company level.

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those 12 institutions from the 7,415 FDIC-insured banking organizations active in December 2007 leaves 7,403 organizations that would be eligible to adopt the Standardized Option. Seven of the twelve mandatory Advanced Approaches institutions are national banks. Out of 1,421 banking organizations with national banks, 1,414 national banking organizations would thus be eligible to adopt the Standardized Option.

As discussed further below, the number of institutions that will ultimately elect to adopt

the Standardized Option is one of the major uncertainties regarding this proposed rule. All banking organizations other than those required to adopt the Advanced Approaches rule are eligible to adopt the Standardized Option. Because adopting the Standardized Option is voluntary, the number of feasible adopters ranges from zero to 7,415 among all FDIC-insured banking organizations and from zero to 1,414 among national banks. Table 1 shows the size distribution and share of total assets for national banks.

Table 1. Size Distribution of National Banks, Aggregated to Top Holding Company, as of December 31, 2007

Asset Size # of Banking

OrganizationsTotal Assets ($ millions)

Share of Total National Bank

Assets Less than $100 million 495 $27,970 0.4%

Between $100 million and $1 billion

779 $228,046 2.9%

Between $1 billion and $10 billion 113 $316,419 4.1%

Greater than $10 billion; Not Mandatory Advanced Approaches

27 $1,385,735 17.8%

Mandatory Advanced Approaches Organizations

7 $5,824,217 74.8%

Total 1,421 $7,782,387 100%

B. Benefits of the Proposed Rule The proposed rule aims to enhance safety and soundness by improving the risk sensitivity of regulatory capital requirements. The proposed rule: 1. Enhances the risk sensitivity of capital charges

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Among its objectives, the proposed rule aims to improve the risk sensitivity of regulatory capital requirements. For example, under current capital rules, residential mortgages generally carry a 50 percent risk weight. However, risk among mortgages tends to increase as the loan-to-value (LTV) ratio increases. Table 2 shows the proposed rule’s risk weights for 1-4 family first lien mortgages. As shown in table 2, risk weights for residential mortgages would increase as the LTV ratio increases. Thus, the minimum capital requirement would rise and fall with risk using the Standardized Option capital calculations. Under current rules, the 50 percent risk weight applies regardless of the mortgage’s LTV ratio. The remainder of this section enumerates and discusses this and other benefits of the proposed rule.

Table 2. Proposed Risk Weights for Qualifying First Lien Residential Mortgages

Loan-to-Value Ratio Risk Weight

60% or less 20% Greater than 60% and less than or equal to 80% 35% Greater than 80% and less than or equal to 85% 50% Greater than 85% and less than or equal to 90% 75% Greater than 90% and less than or equal to 95% 100% Greater than 95% 150%

The proposed rule would offer a greater number of risk weights and would tie those risk weights to external credit ratings. In the case of residential mortgages, the proposed rule would use loan-to-value ratios to assign risk weight categories. By increasing the number of risk weights and incorporating external credit ratings and loan-to-value ratios into the process of assigning risk weights, the proposed rule enhances the risk sensitivity of capital charges relative to current capital rules. Although the proposed rule would continue to use the simplistic risk-bucket approach of current capital rules, including asset-specific information such as loan-to-value ratios or external credit ratings does serve to make the risk bucket assignment more sensitive to idiosyncratic risk characteristics of various assets.

2. Provides for more efficient use of required bank capital Increased risk sensitivity will allow banking organizations to achieve prudent objectives

more efficiently. If the proposed rule can better align capital with risk, then a given level of capital will be able to support a higher level of banking activity while maintaining the same degree of confidence regarding bank safety and soundness. Alternatively, the better alignment of capital and risk could lead to a higher effective level of solvency at the same levels of overall banking activity. Social welfare is enhanced by either the stronger condition of the banking system or the increased economic activity the additional banking services facilitate. Depending on how many institutions elect to adopt the Standardized Option, the benefit in terms of capital efficiency from more closely aligning regulatory capital charges with risk could be significant, in view of the volume of assets at eligible U.S. banking organizations.

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3. Recognizes new developments in financial markets The proposed rule recognizes new developments in financial markets by incorporating

external credit ratings into the process for assigning risk weight categories. To a certain extent, expanding the range of recognized collateral and using loan-to-value ratios also reflects the proposed rule’s efforts to use financial market information to determine capital requirements. By incorporating this more dynamic information into the capital calculation, the proposed rule represents an improvement over the purely static risk-weight approach of current capital rules.

4. Mitigates potential distortions in minimum regulatory capital requirements between

Advanced Approaches banking organizations and other banking organizations One of the principal concerns regarding the implementation of the Advanced Approaches

rule relates to the potential distortions in minimum regulatory capital requirements that might occur as a result of the bifurcated capital rules. This general concern also focused more specifically on potential distortions that might occur in the residential mortgage market because of the expectation that institutions subject to Advanced Approaches rule would generally experience a reduction in their minimum capital requirements for mortgages. By effectively increasing the number of risk weights for residential mortgages from one to eight (see table 2 above), the Standardized Option serves to mitigate potential distortions between Advanced Approaches institutions and other banking organizations. According to the New Accord, the range of potential risk weights is likely to be wider under the Advanced Approaches, from less than 5 percent for mortgages with low default probabilities and low loss given default ratios to over 250 percent for mortgages with high default probabilities and high loss given default ratios.19 This compares to the 20 percent to 150 percent range for mortgages in the Standardized Option. The ultimate impact on minimum regulatory capital depends entirely on the composition of the mortgage portfolio. If an institution adopts the Standardized Option, then its overall capital charge for residential mortgages will fall somewhere between 20 percent and 150 percent, depending on the distribution of its mortgage portfolio across the eight LTV-dependent risk weight categories.

5. Better aligns capital and operational risk and encourages banking organizations to

mitigate operational risk Under the proposed rule, banking organizations adopting the Standardized Option would

use the Basic Indicator Approach (15 percent of a three year average of Gross Income).20 Just as the Standardized Option approach to credit risk replaces the four-bucket approach of the 1988 Accord, introducing an explicit capital calculation for operational risk eliminates the implicit and imprecise “buffer” that covers operational risk (along with other risks) under current capital rules. To the extent that operational risk and gross income are correlated, organizations with relatively more operational risk will have to hold more capital to cover that risk, in contrast to the current undifferentiated approach to operational risk.

19 See Annex 3, Illustrative IRB Risk Weights, page 197 in “International Convergence of Capital Measurement and Capital Standards: A Revised Framework,” Basel Committee on Banking Supervision, June 2004. 20 As mentioned earlier, the proposed rule asks for comments as to whether banks adopting the Standardized Option should be able to use the AMA for operational risk.

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Introducing an explicit capital requirement for operational risk improves how well capital reflects risk at organizations where operational risk dominates other risks. Organizations with significant operational risk but little credit risk exposure have very little capital required under the current system. An explicit measure of operational risk should generate minimum capital requirements at these organizations that are more appropriate to the actual risk.

6. Enhances supervisory feedback Although U.S. banking organizations have long been subject to close supervision, aspects

of all three pillars of the proposed rule aim to enhance supervisory feedback from federal banking agencies to managers of banks and thrifts. Ongoing supervision of the methods organizations use to calculate capital adequacy should provide constructive feedback in keeping with the supervisory review objectives of Pillar 2. Oversight of the reports required as part of the new disclosure requirements of Pillar 3 will give the banking agencies another opportunity to provide useful feedback to bank and thrift management on their risk measurement and risk management techniques. Overall, the proposed rule provides a consistent framework across institutions to gather additional data and insights into risk management that will enhance the dialog between supervisors and bank management. This enhanced feedback could further strengthen the safety and soundness of the banking system.

7. Promotes market discipline through enhanced disclosure The rule seeks to aid market discipline through the regulatory framework by requiring

specific disclosures relating to risk measurement and risk management. Disclosure of this material will certainly enhance the transparency of mandatory and opt-in organizations to the public, banking supervisors, and financial markets, thereby reducing informational asymmetries. Increased disclosure enables financial markets to more accurately impose discipline by increasing the transparency of banking organizations. In addition to facilitating market discipline, such information could play an important role in containing ripple effects when shocks to one organization or one market threaten to spill over. If spillovers are more likely to occur when there is a dearth of information in the market regarding exposures and susceptibility, supplying this information will limit spillover and lessen the likelihood of systemic problems. Overall, market discipline could complement regulatory supervision in bolstering safety and soundness.

As the rule indicates, disclosures made in public financial reports will fulfill the

applicable disclosure requirement. To the extent organizations already disclose this information, these disclosure requirements will not add to the reporting burden. To the extent that organizations do not currently make these disclosures, the requirements will add to the costs of implementation, which we discuss later in the analysis.

8. Preserves the benefits of international consistency and coordination achieved with the

1988 Basel Accord Several important objectives will be achieved through the implementation of The New

Accord. One such goal is the preservation of international consistency and coordination. An important objective of the 1988 Accord was competitive consistency of capital requirements for

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banking organizations competing in global markets. The Standardized Option and advanced approaches of The New Accord continue to pursue this objective. Because achieving this objective depends on the consistency of implementation in the United States and abroad, the Basel Committee has established an Accord Implementation Group to promote consistency in the implementation of The New Accord. Consistent implementation of The New Accord will also help to avoid any cross-border flows of capital that might occur because of regulatory differences across countries.

Achieving international capital consistency also strengthens the global banking system

because of banking externalities. As mentioned earlier in this analysis, capital protects individual institutions from losses and strengthens the ability of the entire U.S. banking system to absorb losses. This externality extends to the global banking system as well. Capital at each institution provides a loss buffer that strengthens the bank, that bank’s domestic banking industry, and the international banking system. International consistency and coordination also strengthen the global banking system by facilitating communication and cooperation among the world’s banking supervisors. Without a consistent set of capital rules across international borders, banking organizations that must adhere to stricter capital regulation could be at a competitive disadvantage relative to institutions facing weaker capital rules.

9. Offers long-term flexibility to banking organizations by providing the ability to opt in

to the Standardized Approach. In an effort to avoid undue regulatory burden, the proposed rule is voluntary. If a

banking organization takes no action in response to this rule, it will continue to operate under current capital rules. The voluntary nature of the proposed rule allows banking organizations the opportunity to weigh the various costs and benefits of adopting the new system. There is no opt-in deadline, so institutions that initially choose to continue with current capital rules, may switch to the Standardized Option at a later date if their cost/benefit tradeoff changes in the future. The proposed rule does not preclude institutions that initially elect to adopt the Standardized Option from undoing that decision. However, they must first notify their primary federal regulator, and a banking organization’s primary federal supervisor could require the institution to use either existing capital rules or the Standardized Option if the supervisor deems that a particular capital rule is appropriate.

C. Costs of the Proposed Rule One of the principles guiding the development of the proposed rule was to avoid undue

regulatory burden. Towards this goal of limiting regulatory burden, the proposed rule allows banking organizations to choose to adopt the revisions in the rule or do nothing and continue to use current risk-based capital rules. Even for those institutions that elect to adopt the Standardized Option, the principal rule change is the relatively simple expansion of the number of risk weights. The proposed rule would also make use of data that are either currently available to the institution, e.g., loan-to-value ratios, or readily available information, e.g., external credit ratings. The Standardized Option does not involve any of the complex modeling of credit risk associated with the Advanced Approaches rule. Organizations adopting the Standardized Option would be able to do so simply by completing new items related to the

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Standardized Option provisions on the quarterly report of financial condition that the banking organization currently submits to its primary federal regulator. Because these rule changes are relatively simple and use readily available data, the cost of adopting the Standardized Option with the Basic Indicator Approach is likely to be fairly moderate, as we discuss in the following section on costs.21

Estimating the costs of the proposed rule presents a number of challenges. As with any

rule, the costs of the proposal include expenditures by banks and thrifts necessary to comply with the new regulation and costs to the federal banking agencies of implementing the new rules. Whereas the fourth quantitative impact study (QIS-4) provided specific cost estimates from banking organizations regarding their estimate of the cost of implementing the Advanced Approaches, no such information exists for the Standardized Option. Although an earlier Advanced Notice of Proposed Rulemaking requested estimates of implementation costs, only one of 73 comment letters included a cost estimate. Further complicating matters, the cost estimate in the one comment letter refers to a broader data gathering effort than anticipated by the banking agencies and consequently provides a cost estimate for establishing a data mart.22 Because of this lack of cost estimates from banking organizations, the OCC found it necessary to use a scope of work comparison with the Advanced Approaches in order to arrive at a cost estimate for the Standardized Option. Based on this rough assessment, we estimate that implementation costs for the Standardized Option could range from $200,000 at smaller institutions to $5 million at larger institutions.

1. Costs to Banking Organizations Explicit costs of implementing the proposed rule at banking organizations fall into two

categories: setup costs and ongoing costs. Setup costs are typically one-time expenses associated with introducing the new programs and procedures necessary to achieve initial compliance with the proposed rule. Setup costs may also involve expenses related to tracking and retrieving data needed to implement the proposed rule. Ongoing costs are also likely to reflect data costs associated with retrieving and preserving data.

The most significant question regarding the costs to banking organizations of the

proposed rule relates to the number of institutions that may elect to adopt it. Because adherence to the proposal is entirely voluntary, it is feasible that zero banking organizations may elect to adopt the Standardized Option, which would result in zero costs to banking organizations. Similarly, it is feasible that all institutions other than those required to adopt the Advanced Approaches may elect to adopt the Standardized Option. Table 3 provides a look at the possible aggregated costs for the adoption scenario for national banks that we use in this analysis.

21 Costs related to new rules typically fall into three categories: new technology, process reengineering, and training. We do not expect adoption of the Standardized Option to involve new technology costs. 22 TD Banknorth, Comment Letter on ANPR for Risk-Based Capital Guidelines: Domestic Capital Modifications, January 18, 2006. The letter states that the initial cost of establishing a data mart “could easily exceed $5 million”.

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Table 3. Cost Estimates for the Standardized Option Adoption by Size, Eligible National Banks, Aggregated to Top Holding Company, December 31, 2007

Asset Size

# of Banking Organizations

Estimated Number of

More Likely Adopters

Estimated Cost of Adoption per

Institution

Aggregate Cost Estimate($ in millions)

Less than $100 million

495 41 $200,000 $8.2

$100 million - $1 billion

779 53 $500,000 $26.5

$1 billion - $10 billion

113 14 $1 million $14

Greater than $10 billion

27 5 $5 million $25

Total 1,414 113 $73.7

As table 3 suggests, the total cost to national banks of adopting the Standardized Option

depends entirely on the number of institutions that elect to adopt the voluntary rule and the size of those institutions. Obviously, if the number of institutions adopting the Standardized Option is zero, then the cost will be zero. At the opposite extreme, if all 1,414 eligible national banking organizations choose to adopt the Standardized Option capital rules, the estimated cost of the rule is $737 million. Based on comment letters and discussions with bank supervision staff, we sought to identify national banks that might be more likely to adopt the Standardized Option. Because one of the principal changes in the Standardized Option affects the risk weighting for residential mortgages, we selected national banks with significant mortgage holdings as the more likely adopters of the new rule.23 We identified 113 national banking organizations that might be more likely to adopt the Standardized Option. We estimate that the total cost of the rule for those national banks will be approximately $74 million.24

23 These banks include national banks with significant mortgage holdings (1-4 family first-lien mortgages comprise greater than 30 percent of the portfolio of institutions with less than $1 billion in assets or 20 percent of the portfolio of institutions with at least $1 billion in assets) as well as national banks that did not meet the well-capitalized threshold for their risk-based capital ratio as of December 31, 2007. 24 This cost estimate assumes that each institution incurs these costs in one year, 2009. Spreading the costs equally over two years and applying a five percent discount rate would yield a present value total cost to national banks of approximately $69 million. We use a five percent discount rate as an approximation to the yield on a ten-year Treasury Bond. Using a discount rate of three percent or seven percent would yield a present value cost of $71 million or $67 million, respectively.

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We discuss further below, in the uncertainty section, the factors that might influence an institution regarding its decision to adopt the Standardized Option. Over time, the Standardized Option may become more appealing to a larger number of banks. The total cost of the proposed rule would consequently increase to the extent that more institutions opt into the Standardized Option over time. At present, it is unclear how many national banks will ultimately elect to adopt the Standardized Option.

Implicit Costs In addition to explicit setup and recurring costs, banking organizations may also face

implicit costs arising from the time and inconvenience of having to adapt to new capital regulations. At a minimum this involves the increased time and attention required of senior bank and thrift management to introduce new programs and procedures and the need to closely monitor the new activities when the proposed rules first take effect. Such heightened oversight will necessarily have to continue until the new programs settle into place. Because of the relatively simple nature of the changes in the proposed rule, the OCC does not anticipate significant time and inconvenience costs. It is likely that an institution that expects the adoption of the Standardized Option to involve significant time and inconvenience costs will choose to remain subject to current capital rules.

2. Government Administrative Costs Like the banking organizations subject to new requirements, the costs to government

agencies of implementing the proposed rule also involve both startup and ongoing costs. Startup costs include expenses related to the development of the regulatory proposals, costs of establishing new programs and procedures, and costs of initial training of bank examiners in the new programs and procedures. Ongoing costs include maintenance expenses for the likely additional examiners and analysts needed to regularly apply potentially more complex supervisory processes. In the case of the Standardized Option, because modest changes to regulatory reporting requirements will capture most of the rule changes, these ongoing costs are likely to be minor.

OCC expenditures fall into three broad categories: training, guidance, and supervision.

Training includes expenses for workshops and other training courses and seminars for examiners. Guidance expenses reflect expenditures on the development of the Standardized Option guidance. Supervision expenses reflect organization-specific supervisory activities.

Although we have not collected OCC expenditure information specific to the Standardized Option, we estimate that the Standardized Option expenditures will be approximately one third of OCC expenditures on the U.S. implementation of the Advanced Approaches. While ultimate OCC expenditures on the Standardized Option depend to a certain extent on the number of institutions that elect to adopt it, guidance and training expenditures will be relatively independent of the adoption rate. Through fiscal year 2006, the OCC spent $10 million on Advanced Approaches guidance, training, and supervision expenses. We estimate that OCC expenses for the Standardized Option will be approximately $4.3 million through 2008. We also expect expenditures of $1 million per year between 2009 and 2011. Applying a

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five percent discount rate to future expenditures, past expenses ($4.3 million) plus the present value of future expenditures ($2.7 million) equals total OCC expenditures of approximately $7 million on the Standardized Option.25

Total Cost Estimate of Proposed Rule Because we do not expect the adoption or non-adoption of the Standardized Option to

carry any social costs outside of the direct costs to banking organizations, the OCC’s estimate of the total cost of the proposed rule includes expenditures by banking organizations and the OCC from the present through 2011. Based on our estimate that 113 national banks will adopt the Standardized Option at a cost to each institution of between $200,000 and $5 million depending on the size of the institution, we estimate that national banks will spend approximately $74 million on the Standardized Option. Combining expenditures by banking organizations and the OCC provides an estimate of $81 million for the total cost of the proposed rule.26

The Uncertainty of Costs and Benefits

As with any proposed rule change, there is bound to be some uncertainty regarding the actual extent of costs and benefits engendered by the new regulation. In addition to uncertainty surrounding costs and benefits that might arise from unanticipated effects of the regulation, there will also be varying degrees of uncertainty regarding fully anticipated costs and benefits. For instance, some costs are certain to occur, but the ultimate cost for each institution remains uncertain.

One area of particular uncertainty is the number of institutions that will choose to adopt

the proposed rule. As pointed out in the discussion of costs above, the total cost of the proposed rule depends entirely on the number of institutions that adopt the Standardized Option and the size of those institutions. While we expect that 113 national banks or fewer will adopt the proposed rule, the actual number could fall anywhere between zero and 1,414 institutions. Corresponding costs could thus fall anywhere between zero and $737 million. Because adoption of the rule is voluntary, each institution will weigh the benefits of adopting the rule against its costs. It is fairly certain, however, that regulated financial institutions will not incur expenses in order to voluntarily adopt a rule that would increase their minimum required capital levels. This understandable behavior combined with the fact that to achieve increased risk sensitivity, the Standardized Option would reduce risk weights for securities with high investment grade ratings and mortgages with low LTV ratios, suggests that institutions with portfolios more heavily weighted toward these types of assets would be more likely to adopt the Standardized Option than an institution with an asset portfolio that contains a significant proportion of below investment grade securities or mortgages with high LTV ratios.

Uncertainty also relates to the overall extent of changes in minimum capital requirements. For instance, because of changing risk weights, one might expect that institutions that elect to adopt the Standardized Option may be inclined to adjust their exposure in favor of

25 Using a discount rate of three percent or seven percent would yield the same result after rounding. 26 Spreading costs to banking organizations over two years and using three percent, five percent, and seven percent discount rates would yield total cost estimates of $71 million, $69 million, or $67 million, respectively.

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lower risk weight assets. However, experience suggests that may not be the case. Current capital rules have different risk weights that would allow institutions to adjust their portfolio toward lower risk weight assets. Rather than clustering in any particular risk-weight category, banking organizations tend to hold a diversified portfolio of assets, suggesting that factors other than regulatory capital risk weights tend to dominate the asset allocation decision. Nevertheless, as with the implementation of the Advanced Approaches, the federal banking agencies intend to monitor the risk-based capital levels of those banking organizations that choose to voluntarily adopt the Standardized Option. Any significant decline in the aggregate minimum required risk-based capital for these banking organizations may warrant modifications to the proposed rule’s risk-based capital requirements.

Another area of uncertainty with any regulatory change is the possibility that it might

create a competitive advantage for some organizations relative to others. One of the principal motivations for developing the Standardized Option proposal, however, was to help mitigate any potential competitive effects of the U.S. implementation of the New Accord’s advanced approaches. Although the OCC’s regulatory impact analysis of the Advanced Approaches concludes that recent economic literature does not reveal any persuasive evidence of sizeable competitive effects, the Standardized Option serves to mitigate any potential distortions in minimum regulatory capital requirements between Advanced Approaches banks and other institutions. Even so, the U.S. banking agencies recognize the need to closely monitor the competitive landscape subsequent to any regulatory change. In particular, the banking agencies intend to monitor and encourage research on competition in banking on an ongoing basis in order to fully assess the proposed rule’s competitive implications. To the extent that undesirable competitive inequities emerge, the agencies have the power to respond to them through many channels, including but not limited to suitable changes to capital adequacy regulations.

IV. ANALYSIS OF BASELINE AND ALTERNATIVES In order to place the costs and benefits of the proposed rule in context, Executive Order

12866 requires a comparison between the proposed rule, a baseline of what the world would look like without the proposed rule, and a reasonable alternative to the proposed rule. The baseline considers the possibility that the proposed Standardized Option is not adopted and current capital standards continue to apply.

The baseline scenario appears in this analysis in order to estimate the effects of adopting

the proposed rule relative to a hypothetical regulatory regime that might exist without the Standardized Option. Because the baseline scenario considers costs and benefits as if the proposed rule never existed, we set the costs and benefits of the baseline scenario to zero. Obviously, banking organizations face compliance costs and reap the benefits of a well-capitalized banking system even under the baseline. However, because we cannot quantify these costs and benefits, we normalize the baseline costs and benefits to zero and estimate the costs and benefits of the proposed rule and alternative as deviations from this zero baseline.

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1. Baseline Scenario: Current capital standards based on the 1988 Basel Accord continue to apply.

Description of Baseline Scenario

Under the Baseline Scenario, current capital rules would continue to apply to all banks in the United States that are not required to adopt the Advanced Approaches rule. The United States would not adopt the proposed Standardized Option, but implementation of the Advanced Approaches rule would continue. Because the U.S. implementation of the Advanced Approaches allows institutions to opt in, there is some uncertainty in this baseline scenario regarding the number of U.S. banking organizations that would not be subject to the Advanced Approaches.

Change in Benefits: Baseline Scenario Staying with current capital rules instead of adopting the Standardized Option would

eliminate all of the benefits of the proposed rule described earlier. Table 4 lists the benefits of the proposed rule and indicates whether the baseline scenario would capture these benefits. Under the baseline, banking organizations not subject to the Advanced Approaches would not be able to voluntarily elect Standardized Option capital rules. Institutions that would have adopted the proposed rule would not be able to take advantage of the enhanced risk sensitivity of the Standardized Option capital charges and the more efficient use of bank capital which that implies.

Table 4. Benefit Comparison of Proposed Rule with Baseline Scenario

Benefit Proposed Rule

Baseline: No Standardized Option

1. Enhances risk sensitivity of capital charges Yes No 2. More efficient use of required capital Yes No 3. Recognizes new developments in financial markets Yes No 4. Mitigates potential distortions in minimum regulatory capital requirements Yes No

5. Better aligns capital and operational risk and encourages banks to mitigate operational risk Yes No

6. Enhances supervisory feedback Yes No 7. Enhanced disclosure promotes market discipline Yes No 8. Preserves the benefits of international consistency and coordination achieved with the 1988 Basel Accord Yes No

9. Ability to opt in offers long-term flexibility to banking organizations Yes No

Without the Standardized Option, an institution would have to choose between the Advanced Approaches and the status quo. The baseline without the Standardized Option would leave a level playing field for all the non-Advanced Approaches banks. However, the absence of

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an opportunity to mitigate potential distortions in minimum required capital would likely diminish this benefit in the eyes of an institution concerned about potential distortions created by the Advanced Approaches.

Changes in Costs: Baseline Scenario

Continuing to use current capital rules would eliminate the costs of adopting the proposed rule as well as the benefits. As discussed above, under the proposed rule we estimate that organizations would spend up to $74 million on implementation-related expenditures if 113 national banks elect to adopt the Standardized Option. Retaining current capital rules would eliminate any costs associated with adopting the proposed rule, even though banking organizations would only incur those costs if they choose to do so. Also, because the proposal would rely on data that is readily available, and imposes relatively modest changes in data reporting and information-maintenance requirements, those avoided costs are relatively modest.

Even if the proposed rule were dropped, the original concerns that led to the proposal would remain and likely could require some sort of policy response. In that case, costs could change depending on the eventual regulatory response.

2. Alternative: Require all U.S. banking organizations not subject to the Advanced Approaches to adopt the Standardized Option.

Description of Alternative

The only change under the alternative is that adoption of the proposed rule would be mandatory rather than voluntary. Under this alternative, the provisions of the proposed rule would remain intact and apply to all national banks that are not subject to Advanced Approaches capital rules. Institutions subject to the Advanced Approaches would include mandatory Advanced Approaches institutions and those institutions that elect to adopt the Advanced Approaches rule.

Change in Benefits: Alternative

Because there are no changes to the elements of the proposed rule under the alternative, the list of benefits remains the same. Among these benefits, only one benefit is lost by making the proposed rule mandatory: the benefit derived from the fact that the proposed rule is voluntary and allows institutions to opt in when it is advantageous for the institution to do so. As for the benefits relating to the enhanced risk sensitivity of capital charges, because adoption of the Standardized Option is mandatory under the alternative more banks will be subject to the Standardized Option provisions and the aggregate level of benefits will be higher. Because we estimate that 113 national banks would adopt the Standardized Option voluntarily, this difference in the aggregate benefit level would be considerable. Table 5 summarizes the benefit comparison between the proposed rule and the alternative.

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Table 5. Benefit Comparison of Proposed Rule with Alternative

Benefit Proposed Rule Alternative: Mandatory

Standardized Option 1. Enhances risk sensitivity of capital charges Yes Greater 2. More efficient use of required capital Yes Greater 3. Recognizes new developments in financial markets Yes Yes

4. Mitigates potential distortions in minimum regulatory capital requirements Yes Yes

5. Better aligns capital and operational risk and encourages banks to mitigate operational risk Yes Greater

6. Enhances supervisory feedback Yes Greater 7. Enhanced disclosure promotes market discipline Yes Greater 8. Preserves the benefits of international consistency and coordination achieved with the 1988 Basel Accord

Yes Yes

9. Ability to opt in offers long-term flexibility to banking organizations Yes No

Changes in Costs: Alternative

Clearly the most significant drawback to the alternative is the dramatically increased cost of applying a new set of capital rules to all U.S. banking organizations. Under the alternative, direct costs would increase for every U.S. banking organization that would have elected to continue to use current capital rules under the proposed rule. Referring back to table 3, the cost estimate for the alternative is the total cost estimate for a 100 percent adoption rate of the Standardized Option. With 1,414 national banking organizations eligible for the Standardized Option, the cost of the alternative to banking organizations is approximately $737 million. This number may be somewhat less depending on the number of national banks that elect to adopt Advanced Approaches capital rules, but it is much greater than our cost estimate of $74 million for the proposed rule.

Because of enhanced risk sensitivity, aggregate social benefits would increase by making the Standardized Option mandatory. However, private costs would increase considerably. For some riskier institutions, the benefits of increased risk sensitivity of capital charges would likely outweigh the private cost of the Standardized Option implementation. However, for the vast majority of well capitalized institutions with relatively balanced portfolios, the private cost of implementing the Standardized Option most likely exceeds the marginal social benefit of adopting its more risk sensitive approach to determining regulatory capital.

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3. Overall Comparison of Proposed Rule with Baseline and Alternative

The New Accord and its U.S. implementation seek to incorporate risk measurement and risk management advances into capital requirements. Risk-sensitive capital requirements are integral to ensuring an adequate capital cushion to absorb financial losses at financial institutions. In implementing the Standardized Option in the United States, the agencies’ intent is to enhance risk sensitivity while maintaining a regulatory capital regime that is as rigorous as the current system. Total capital requirements under the Standardized Option will better allocate capital in the system. This will occur regardless of whether the minimum required capital at a particular institution is greater or less than it would be under current capital rules.

The objective of the proposed rule is to enhance the risk sensitivity of capital charges for institutions not subject to the Advanced Approaches capital regulations. The proposal also seeks to mitigate any potential distortions in minimum regulatory capital requirements that the U.S. implementation of the Advanced Approaches rule might create between large and small banking organizations. Like the Advanced Approaches rule, the anticipated benefits of the Standardized Option proposal are difficult to quantify in dollar terms. Nevertheless, the OCC believes that the proposed rule provides significant benefits without harming the safety and soundness of the banking industry or the security of the Federal Deposit Insurance system. To offset the costs of the proposed rule, its voluntary nature offers regulatory flexibility that will allow institutions to adopt the Standardized Option on a bank-by-bank basis when an institution’s anticipated benefits exceed the anticipated costs of adopting this regulation.

The banking agencies are confident that the proposed rule will enhance the risk sensitivity of institutions electing to adopt the Standardized Option while the safety and soundness of institutions electing to forgo the Standardized Option and Advanced Approaches rule will not diminish. On the basis of our analysis, we believe that the benefits of the proposed rule are sufficient to offset the costs of implementing the proposal. However, we believe it is best to make the proposed rule voluntary in order to let each national bank decide whether it is in that institution’s best interest to adopt the Standardized Option. This will help to ensure that the costs associated with implementation of the Standardized Option do not rise precipitously and outweigh the benefits. Because adoption is voluntary, the proposed rule offers an improvement over the baseline scenario and the alternative. The proposed rule also offers an important degree of flexibility unavailable with either the baseline or the alternative. The baseline does not give banking organizations a way into the more risk sensitive Standardized Option and the alternative does not offer them a way out. The alternative would compel most banking organizations to follow a new set of capital rules and require them to undertake the time and expense of adjusting to these new rules. The proposed rule offers a better balance between costs and benefits than either the baseline or the alternative. Overall, the OCC believes that the benefits of the proposed rule justify its potential costs.